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Using custodial accounts
A custodial account is an account set up by one party, managed and overseen by another party, and whose assets are intended for the benefit of yet another party.
Custodial accounts are often tax-advantaged accounts. With some tax-advantaged accounts, your contributions are tax-deductible.
With other custodial accounts, the money you take out of the account is exempt from income taxes. In almost all cases, tax-advantaged accounts allow your contributions to grow, or accumulate, tax-free as long as they remain invested in the account.
Custodial accounts are often used to save for college, retirement or manage your estate. They are also used to gift or transfer assets to children and grandchildren.
Some of the custodial accounts you may use for education planning are qualified tuition plans and Coverdell education savings accounts.
Qualified tuition plans (also called 529 plans) are state-sponsored college savings plans. All states offer these plans, which allow you to contribute to a child's or grandchild's college account. Contributions are income tax-deductible for certain states. For all of these plans, your contributions grow tax-deferred and the earnings are tax-exempt if funds withdrawn from the account are spent on qualified higher education expenses.
Coverdell education savings accounts (formerly called education IRAs) are also a form of a custodial account. You may contribute up to $2,000 a year to an education savings account for each child, grandchild or other beneficiary. Contributions to education savings accounts begin to phase out at higher incomes.
For single persons, the phase-out begins when modified adjusted gross income (MAGI) reaches $95,000. Allowable contributions phase out at $110,000. For married persons filing a joint return, the phase-out limits are exactly twice as much.
The Economic Growth and Tax Relief and Reconciliation Act of 2001 expanded the benefits of qualified tuition plans and education savings accounts. Both of these account types give parents and grandparents greater control over the assets. Qualified tuition plans, in particular, work in the child's favor when applying for college financial aid since the assets are considered as belonging to the parents.
The traditional workhorse custodial accounts have been UGMA/UTMA accounts. UGMA/UTMA accounts are taxable accounts that allow you to gift or transfer assets to a minor. They allow you to benefit from the kiddie tax on the first $1,600 of income in 2005. Additional income is taxed at your tax rate. A major drawback of UGMA/UTMA accounts is that the child controls the assets in the account once he or she reaches majority age. (Age 18 in some states and 21 in others.)
Custodial accounts are also used to manage your estate. A trust account allows you to contribute a certain amount to a child, grandchild, or other beneficiary (often, a charitable organization).
The trustee acts as custodian, managing the assets and distributions as you specify when you execute the trust. A trust account is often used for gifting your wealth. For 2005, you may give up to $11,000 a year, tax free, to each beneficiary.
Retirement accounts also have features of custodial accounts, except that you (and a spouse) are the intended beneficiary rather than someone else.
Whether you use a traditional or Roth IRA, or participate in an employer-sponsored retirement plan such as a 401(k) plan, you are essentially opening an account for your own future use.
Tax laws require a custodian to manage a retirement account, even though you can determine how to invest the assets. A bank, brokerage or other financial institution is frequently the custodian. Traditional IRAs and 401(k) plans allow you to make tax-deductible contributions up to a yearly limit. Earnings grow tax-deferred until you begin to take money out of the account.
With Roth IRAs, you make contributions with after-tax dollars but your earnings are tax-free, provided you have kept the same account open for at least five years.
Except for certain hardships, you have to wait until you turn age 59-1/2 to take money out of these retirement accounts without also paying a 10% penalty. Roth IRAs give you more flexibility, since they don't have required minimum distributions.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
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